More on currency futures

I received some offline comments on my earlier blog post
on currency futures in India and would therefore like to elaborate on
my views.

I see this market evolving in three phases:

In phase one, the market is largely retail. Retail traders simply
did not have access to the forward market and assuming that they would
like to use currency derivatives, the futures market is the only
option for them. Some of the retail participation would be purely
speculative, but there would be substantial hedging demand as
well. The fact is that you can have an exposure to exchange rates even
if all your economic transactions are with domestic participants and
are denominated in Indian rupees. For example, a small pepper farmer
who sells produce in the local market in Indian rupees is exposed to
currency risk to the extent to which domestic pepper prices are linked
to global prices denominated in dollars or other foreign currency. I
believe that retail demand alone would be sufficient to take the
market to the point where it has sufficient liquidity and depth for
amounts of $50,000 to $200,000.

This would bring the market to phase two where the liquidity and
depth is enough to attract small and medium enterprises (SMEs). SMEs
do not trade in the interbank market – they do forward contracts
with their regular bank and face quite significant transaction
costs. It is easy for the futures market to be competitive for this
segment in terms of liquidity and depth. The futures market have the
advantage of not tying up credit limits, but have the disadvantage of
daily mark to market cash flows. Assuming that the broking business in
India is more price competitive than the banking business, I expect
brokers to find ways of meeting SME hedging demand at a lower
all-in-cost than the banks do. Large SME participation would provide
the market with good liquidity at a depth of around a million
dollars.

At this stage, the market is ready for phase three, where the
market starts competing with the inter bank market for the smaller
lots traded there. It is at this point (probably a year or more from
today) that the restrictions on the futures market in terms of FII
participation and client level position limits will start to
bite. Assuming that these restrictions are lifted by then, the futures
market could provide stiff competition to the inter bank market if the
exchanges provide strong support for direct market access (DMA) and
algorthmic trading and persuade agencies like Reuters and Bloomberg to
give enough visibility to futures market quotes.